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The Problem with the Phillips Curve

Saturday, August 16th, 2014

7046305715_824084ddf1_o I remember sitting in my intermediate macroeconomics class at Johns Hopkins, when the Professor was trying to develop the concept of the Phillips Curve, which posits a trade-off between labor unemployment and price inflation, at least in the short run.  The time was the Fall of 1980, and macroeconomics was trying to catch up with what happened with stagflation, because that was not something that expected would come from their policy recommendations that offered the politicians a free lunch.

This trade-off underlies the concept of the dual mandate of the Federal Reserve, where they are not only to try to restrain price inflation, but also aim for full labor employment.  I don’t think it is realistic to do this for two reasons.

1) For the theory of the Phillips Curve to work, the central assumption is that price inflation funnels directly into wage inflation.  This is a questionable assumption, as I will explain below.

2) The FOMC has a hard enough time using monetary policy to restrain or accelerate price inflation.

Why might price inflation vary from wage inflation?  There are two main reasons in the present: technological improvements that require less labor to produce the same or better output, and an increase in overseas laborers available to produce good or services outside the US for sale inside the US.  Notice I am not mentioning immigration, though that might have a small impact on the wages of the lowest-skilled jobs in the short run.

I see both of these factors acting at present, which until our economy adjusts to create more jobs, initially at lower pay than most will want, will restrain the growth in wages, particularly adjusted for inflation.

  1. Now, give Janet Yellen some credit, because she recognizes the weakness of looking at the headline unemployment number as a guide to policy and has broadened out her labor market indicators to reflect that a low U-3 unemployment rate doesn’t mean the labor market is great.  She looks at the rates of layoffs/firings, job openings, voluntary quitting, hiring, and labor force partipation, among others.
  2. This is similar to what I suggested in a recent post on labor underemployment.  Payments to labor are a smaller fraction of the economy, and real wages have flatlined.
  3. That said, I don’t think the Fed can succeed here, because the relationship between monetary policy and real wages is nonexistent as far as I can see.  The Fed is better at inflating assets in an era where the better-off save, than it is in inflating prices, which it more direct effect on than wages.
  4. There is slow but steady pressure for wage rates to equalize globally, slowly but surely.  Being born in the West is not in itself a ticket to above average wages.

I don’t blame the Fed for the poor labor market conditions; it’s not in their power.  Maybe we can blame Congress and the Executive Branch for making laws that inhibit hiring and firing, both at the national and state levels.  We might blame the schools for not taking a more balanced approach to education, stressing vocational education alongside a strong liberal arts education that includes real science and math.  Parents, if the school systems don’t do this, if your children will listen to you, get them thinking along these lines.

You are your own best defender with respect to your own employment, so put some thought into alternative work, should you find yourself unemployed.  Analyze how you can meet the most needs/demands of others and fill those needs/demands, and you will never lack work.

I wish you the best in a tough labor market.

On Research Sources and Trading Rules

Friday, August 15th, 2014

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On a letter from a reader:

In your Industry Ranks August 2014 post you mentioned that you use Value Line analytic tools.

If it is not a secret, what other third-party research and analysis do you use, especially for company analysis (MorningStar, Zacks…)?

Do you rely/subscribed on Interactive Brokers “IBIS Research Essentials?” If yes, do you find it valuable?

In addition, if you do not mind, you said that you make adjustments to your portfolio once in a quarter. Does it mean that you do not look at market quotes during the day at all and, hence, you are not subscribed to IB real-time data (NYSE, Nasdaq, US Bond quotes?)

I would greatly appreciate your answers.

Thank you very much!

I don’t like to spend money on aids for research.  I can only think of two things that I pay for and actively use:

I do pay for quotes at Interactive Brokers, but because I don’t trade much, I don’t pay for the expensive packages.  I have not subscribed to Interactive Brokers “IBIS Research Essentials.”

But many of the best things in life are free.  My local library offers free Morningstar and Value Line online… I don’t have to leave my home to use it, an it is open all the time.  If I go two blocks to my library, there is a wealth of business data and books that I can draw upon.

That said, the Web offers a lot of free resources, and I make use of:

  • Yahoo Finance, which I think I have been using since 1996 — pretty close to its inception.  There is no better place on the web to get business news tagged for each corporation.  It has gotten better since removing some feeds that have questionable value.  There’s a great range of information to be had in a wide number of areas.
  • FRED, which just keeps getting better… more data series, more ways to use them… and I have been using them since it was a “bulletin board” (remember those?) back in 1991 or so.
  • Bloomberg.com is excellent in the general and business news areas.
  • Beyond that, Reuters, Marketwatch, the New York Times, and the Financial Times (especially FT Alphaville) have excellent business news coverage.  With the last two, NYT & FT, you have to decide if you want to pay for it, and I don’t pay for them.
  • When I do my stock research, I generally go to the SEC website and read the documents.  Then I go to Yahoo Finance and the company’s own website for color.
  • For bonds, bond funds and ETFs, I go to the provider websites, Morningstar, and the Wall Street Journal’s Market Data section.  I can visit FINRA Trace if I need to see how individual bonds have been trading.
  • Finally there is a lot of wisdom in many bloggers out there, and I strongly recommend you get to know them.  Some of the best are expertly curated each day at Abnormal Returns by Tadas Viskanta.

Now as to your question as to whether I look at prices of assets in my portfolio: in general, I check them 3-5 times a day, usually at a point where I will be switching tasks.  I sort my stocks two ways at that time:

  1. By absolute percentage change descending — all of the largest movers are at the top of the screen, and I can look for patterns and trends, which may make me check Yahoo Finance for news.  But that doesn’t make me trade, unless it ends up revealing something that I think will get a lot better or worse, and the market hasn’t figured that out yet.  (That doesn’t happen often.)
  2. By size of positions — if a position has gotten too large, I trim some back.  If it has gotten too small, I stop and research why the price has fallen.  If I am convinced that the stock offers significant returns, and low downside risk, I add a little to the position.  (See Portfolio Rule Seven for more details.)  In a rare number of cases, about once every two years, I will “double weight” the position that has fallen.  So far, all of those have worked over the last 14 years.  But if I realize that the company is unlikely to return anything comparable to the other stocks in my portfolio, I sell it.

Portfolio Rule Seven trades maybe amount to 3-12 small trades per quarter.  More trades come when the market is trending, fewer when it is choppy.  Portfolio Rule Eight is where I do the big trades once per quarter, comparing each stock in my portfolio against a group of potential replacements.  I usually sell 2-4 companies, and then buy a similar number of replacements.  That has my portfolio turn over at a 30%/year rate.  More details available in the article Portfolio Rule Eight.

In general, it is wise for both amateur and pro investors to trade by rule.  Take as much emotion out of the process as possible, and avoid greed and panic.  It is genuinely rare that decisions have to be made quickly, so take your time, do your analysis, and try to find assets with good long-term prospects.

Can the “Permanent Portfolio” Work Today?

Wednesday, August 6th, 2014

Another letter from a reader:

Dear Mr. Merkel:

I just discovered your blog through Valuewalk, which I read most days. I haven’t read much yet on your blog, but from what I’ve seen, I really like your insights and comments.

I’ve been thinking for a long time about the idea of a permanent portfolio concept, based on writing from years ago of an investment analyst, Harry Browne, now deceased. I’ve been thinking about this for my own investment requirements and also because I intend to write a book on the subject.

The big problem with a permanent portfolio today, versus 30 years ago, in my judgement, is identifying a long term fixed income vehicle would survive a major financial collapse. Browne always used 30 year US Treasury bonds, in an era when it seemed clear those bonds could survive a monetary deflation.

Of course, the Fed isn’t about to institute a policy of sustained monetary deflation any time soon, on a voluntary basis. Any such deflation would occur, either because the Fed were unable or unwilling to monetize assets fast enough to head off cascading cross defaults and massive bonk failures; or because the Fed decided to let the house of cards collapse, in some future recession-panic, because it became obvious to a plurality of Fed governors that to prop up the house of cards would guarantee hyper inflation in short order. Of course, a hyper inflation would not only destroy the financial system, including the central bank; it would overturn the established political order, and cause a famine as the division of labor fell apart. 

I think a monetary deflation will happen sooner or later, because of a financial “accident” (that reasonable people can foresee). Even if the central banks were to cause a hyper inflation, when that inflation ends after two or three years, the currency must be renounced. Then we would get deflation for a while via some new currency.

Since I think the deflation risk is realistic, I’m trying to figure out what-if any-bond instruments could survive deflationary destruction. Obviously, in a monetary deflation, all investment prices plummet, except default-free bonds. Default free bonds would rise in price, as interest rates plummeted. However, I’m not clear as to what bonds might work as vehicles in a permanent portfolio, because T bonds are no longer a reliable safe haven from eventual political default.

There might well be sovereign bonds in other countries that are more friendly to free enterprise and private property than contemporary US, and hence less prone to sovereign bond default,  but this introduces the risk of currency fluctuations. So it’s not a perfect solution. Perhaps some foreign sovereign debt combined with US Treasury debt would partly work. It has also occurred to me that some US utility or pipeline firm etc. might offer debt or preferred stock or other forms of fixed income debt/equity ownership that would survive default. In a terrible depression, I’d assume some utility companies would continue to function although, of course, not flourish. Obviously, any such debt or equity would be a very special situation, since most firms are now loaded to the gills with debt, making them poor risks to survive a crushing deflation.

My impression is all this is right up your ally. (Except for my musing-theorizing about the risk of monetary deflation, which no doubt makes me seem like a religious fanatic or political crazy.) Anyway, I’d be interested if you think this problem can be solved. In other words, do you think some private debt issues that are long term or even medium term exist to be discovered that could avoid default in a huge deflationary depression? How would you go about conducting a search for such safe U.S. corporate bonds or other fixed income instruments?

What I really need to do is immerse myself in reading about fixed income analysis. Which I hope to get to in a few months.

None of my fixation with bonds has to do with forecasting a decline in interest rates; until the next crisis, rates on the long end could easily climb. I’m looking for a secure volatile instrument that would gain in price as other investments were falling during a financial panic and subsequent depression.

Thanks for reading through all this. I look forward to spending a lot of hours in the future on your blog.

Yours truly,

Dear Friend,

I have written about the Permanent Portfolio concept here.  I think it is valid.  At some point in the near term, I will update my analysis of the Permanent Portfolio, and publish it for all to see, which I have not done before.

In a significant inflation scenario, gold would soar, long T-bonds would tank, T-bills would actually earn nominal but not real money, and stocks would likely trail inflation, aside from investors that invest in low P/E stocks.  The permanent portfolio would likely do okay.

Same  for a deflation scenario.  Stocks will muddle. T-bonds will do well.  T-bills will do nothing.  Gold will do badly.  That said, the permanent portfolio concept is meant to be an all-weather vehicle, and has done well over the last 44 years, with only 3 losing years, and returns that match the S&P 500, but with half the volatility.

I’m usually not a friend of ideas like this, but the Permanent Portfolio chose four assets where the price responses to changes in real rates and inflation fought each other.  The rebalancing method is important here, as it is a strategy that benefits from volatility.

With respect to where to invest in fixed income to benefit from a depression is a touchy thing — it’s kind of like default swaps on the US government, which are typically denominated in Euros.  How do you know that the counterparty will be solvent?  How do you know that the Euro will be worth anything?

Personally, I would just stick with long US Treasuries.  The US has the least problems of all the great powers in the world.  You could try to intensify you returns by overweighting long Treasuries, but that is making a bet.  The Permanent Portfolio makes no bets.  It just takes advantage of economic volatility, and rides the waves of of the economy.  As a group, stocks, T-bonds, T-bills, and gold, react very differently to volatility, and as such do well, when many other strategies do not.

Warren Buffett is “scary smart,” so says Charlie Munger, who is “scary smart” himself.  I think Harry Browne was “scary smart” with respect to the Permanent Portfolio idea.  But am I, the recommend-er “scary smart?”  I do okay, but probably not “scary smart,” so take my words with a grain of salt.

Sincerely,

David

PS — As an aside, I would note that if everyone adopted the “Permanent Portfolio” idea — gold would go through the roof, because that is the scarcest of the four investments.

Regarding Underemployment

Saturday, August 2nd, 2014

This is just meant to be a few thoughts.  I haven’t worked everything out, but I want to talk about how the labor markets are weak.

Yes, the headline statistics are strong.  The U-3 unemployment figure is low at 6.2%.  But look at a few other statistics:

My, but wages as a share of GDP has been falling.

And real wages have flatlined.  No surprise that many feel pinched in the present environment.  Even the Federal Reserve Chairwoman Janet Yellen expresses her doubts about the labor markets, which was expressed through the most recent FOMC Statement.

The problem is this: the relationship between labor employment and monetary policy is weak.  It is weaker than pushing on a string.  There are two major factors retarding the US labor market, and they are globalization and increased productivity from technology.

The value of knowledge is rising relative to less-skilled labor.  As such, we are seeing increased income inequality in the US, but lower income inequality globally.  Bright people in foreign lands who can transmit their skills over the internet can do better for themselves, even as more expensive counterparts in the US lose business.

Call this the revenge of the nerds.  The internet enables bright people to profit from their differential knowledge, as it can be applied to wider opportunities.

Think of India for a moment.  Many bright people with advanced degrees, but education amounts to little unless you can use it for your own benefit.

Here’s my main point.  The FOMC con’t do much about the labor markets; their power is weak.  The bigger factors of globalization and technology can’t be fought.  They are too big.

Thus, you are on your own.  The US Government does not have the power to re-create the unique middle class prosperity of the ’50s and ’60s.  If you work for others, you are not your own master.  Aim to make yourself the master of your situation, by making yourself invaluable to your clients.

Social Security Troubles

Thursday, July 31st, 2014

We have known for many years that Social Security’s Disability Trust Fund was in far worse  shape than the Retirement Trust Fund, which is also not in good shape.  The rolls for Social Security Disability have risen dramatically since 2009, with many applying for disability amid a time where jobs are hard to find.  Personally, I think that people should plan for their own possible disability, and it not be something that the government covers.

That said, the disability trust fund will run out of money in 2016.  The most likely result in my opinion, is that  the disability trust fund will borrow from the the retirement trust fund, accelerating the insolvency of the retirement trust fund, currently scheduled to make a change to payments in 2026, when it has only one year of payments left in the trust fund, and will have to pro-rate all payments, so that the payments will be made from existing tax payments plus assets on hand.  This means that social security retirement and disability payments will be cut by around 27%.

The politics of this is complicated, and I don’t pretend to have an absolute answer to how this will all work out.  My past dealings with these issues indicate that if the problem can be deferred, it will be deferred.   Borrowing from the retirement trust fund ruffles few feathers, and allows politicians 10 years or so of breathing room, after whichthey may have resigned or retired.

At some point in the future the following phrase will be common: “You got what you deserved, because you trusted the government.”  Add in the troubles at Medicare, where the trust fund also will run out before 2020.

If you are relying on Social Security, you are in a bad spot,  Either taxes will be raised, or benefits will be cut, either across-the-board, or selectively.

This will be a fight, as most other things in our government budget are, and there is no telling how it will turn out.  There is only one certain thing: if we had dealt with this 25-35 years ago, we would not be in this pickle now.  Shame on our parents’ generation, and shame on us, if you are over age 35.  More guilt to those who are older.

Redacted Version of the July 2014 FOMC Statement

Wednesday, July 30th, 2014
June 2014July 2014Comments
Information received since the Federal Open Market Committee met in April indicates that growth in economic activity has rebounded in recent months.Information received since the Federal Open Market Committee met in June indicates that growth in economic activity rebounded in the second quarter.This is another overestimate by the FOMC.
Labor market indicators generally showed further improvement. The unemployment rate, though lower, remains elevated.Labor market conditions improved, with the unemployment rate declining further. However, a range of labor market indicators suggests that there remains significant underutilization of labor resources. More people working some amount of time, but many discouraged workers, part-time workers, lower paid positions, etc.
Household spending appears to be rising moderately and business fixed investment resumed its advance, while the recovery in the housing sector remained slow.Household spending appears to be rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.No real change

 

Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.No change.  Funny that they don’t call their tapering a “restraint.”
Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.Inflation has moved somewhat closer to the Committee’s longer-run objective. Longer-term inflation expectations have remained stable.Finally notes that inflation has risen.  TIPS are showing slightly higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.60%, up 0.14% from June.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators and inflation moving toward levels the Committee judges consistent with its dual mandate.Adds in inflation, also changes measure of the labor market to broaden it from “conditions” to “indicators,” not that that will help much.

They can’t truly affect the labor markets in any effective way.

The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced and judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat.CPI is at 2.1% now, yoy.  They shade up their view on inflation’s amount and persistence.
The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.No change.
In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in July, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $15 billion per month rather than $20 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $20 billion per month rather than $25 billion per month.In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in August, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $10 billion per month rather than $15 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $15 billion per month rather than $20 billion per month.Reduces the purchase rate by $5 billion each on Treasuries and MBS.  No big deal.

 

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.No change
The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.No change.  But it has almost no impact on interest rates on the long end, which are rallying into a weakening global economy.
The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.No change. Useless paragraph.
If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetingsNo change.  Says that purchases will likely continue to decline if the economy continues to improve.
However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.No change.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.No change.
In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.No change.  Monetary policy is like jazz; we make it up as we go.  Also note that progress can be expected progress – presumably that means looking at the change in forward expectations for inflation, etc.
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.No change.  Its standards for raising Fed funds are arbitrary.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.No change.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No change.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Narayana Kocherlakota; Loretta J. Mester; Charles I. Plosser; Jerome H. Powell; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Narayana Kocherlakota; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo.Plosser dissents.  Finally someone with a little courage.
 Voting against was Charles I. Plosser who objected to the guidance indicating that it likely will be appropriate to maintain the current target range for the federal funds rate for “a considerable time after the asset purchase program ends,” because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee’s goals.Thank you, Mr. Plosser.  The end to easing is coming, but what will happen when it starts to bite?

 

Comments

  • The two main points of this FOMC statement are: 1)  The Fed recognizes that inflation has risen, and is likely to persist. 2)   Despite lower unemployment levels, labor market conditions are still pretty punk.  Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Markets don’t move much on the news.  Really, not a lot here.
  • Small $10 B/month taper.  Equities and long bonds both rise.  Commodity prices rise.  The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The FOMC needs to chop the “dead wood” out of its statement.  Brief communication is clear communication.  If a sentence doesn’t change often, remove it.
  • In the past I have said, “When [holding down longer-term rates on the highest-quality debt] doesn’t work, what will they do?  I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.  The Fed is playing with forces bigger than themselves, and it isn’t dawning on them yet.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.

Book Review: Panic, Prosperity, and Progress

Friday, July 25th, 2014

PPP I love economic history books, and I believe that most investors should read economic history.  History offers a broader paradigm for analyzing investment situations than mathematical models do.

Mark Twain is overquoted on this, but only because he deserves to be quoted:
“History doesn’t repeat itself, but it does rhyme.”

You can get a lot of insights into the present by reading this book.  So many disasters occurred because people presumed that the future would be much like the past, and they ended up being the ones that took the large losses.

Further, this book will point out that how an asset is held will make a difference in its future performance.  When there is not a lot of debt behind an asset, there may be good prospects.  But when there is a lot of debt behind an asset, prospects are not so good because those that own the asset are relying on the asset to perform.  Those who own an asset free and clear may get hurt if the price falls, but they won’t be ruined like the guy who has borrowed to own it.

This book takes on every major systemic crisis from the Tulip Bubble to the recent Housing/Banking crisis.  This is my bread & butter, but I learned things in many of the chapters regarding things I thought I knew well.  Truly, a great book.

What Could Have Made the Book Better

Financial crises don’t appear out of nowhere.  Leaving aside war on your home soil, plague, famine, communism, etc., there is usually a boom that gives way to a bust.  In some of his chapters, he could have spent more time describing the boom that led to the bust.  This is important, because readers need to learn intuitively that the boom-bust cycle is normal. NORMAL!

Ignore the economists who think they can control the economy.  They can’t do it, and this book helps to say that.  Economists are always behind the curve.  Politicians are even further behind the curve.  Regulators are still further behind the curve, and usually do the wrong thing during crises as a result.

The author could have done more to suggest how individuals and policymakers should respond to financial crises.  Better to have a book that advises us, than one that just reports.

Quibbles

On pages 421-422, he shows that he doesn’t get securitization, and blames the rating agencies, who were forced to rate novel debt for which they did not have a good model because the regulators outsourced credit risk measurement to them.

Summary

Most people would benefit from this book.  It will teach you about financial crises and their aftermath.  If you want to, you can buy it here: Panic, Prosperity, and Progress: Five Centuries of History and the Markets (Wiley Trading) (Hardback) – Common.

Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

 

On Current Credit Conditions

Friday, July 18th, 2014

This should be short.  Remember that credit and equity volatility are strongly related.

I am dubious about conditions in the bank loan market because Collateralized Loan Obligations [CLOs] are hot now and there are many that want to take the highest level of risk there.  I realize that I am usually early on credit issues, but there are many piling into CLOs, and willing to take the first loss in exchange for a high yield.  Intermediate-term, this is not a good sign.

Note that corporations take 0n more debt when rates are low.  They overestimate how much debt they can service, because if rates rise, they are not prepared for the effect on earnings per share, should the cost of the debt reprice.

It’s a different issue, but consider China with all of the bad loans its banks have made.  They are facing another significant default, and the Chinese Government looks like it will let the default happen.  That will not likely be true if the solvency of one of their banks is threatened, so keep aware as the risks unfold.

Finally, look at the peace and calm of low implied volatilities of the equity markets.  It feels like 2006, when parties were willing to sell volatility with abandon because the central banks of our world had everything under control.  Ah, remember that?  Maybe it is time to buy volatility when it is cheap.  Now here is my question to readers: aside from buying long Treasury bonds, what investments can you think of that benefit from rising implied volatility and credit spreads, aside from options and derivatives?  Leave you answers in the comments or email me.

This will sound weird, but I am not as much worried about government bond rates rising, as I am with credit spreads rising.  Again, remember, I am likely early here, so don’t go nuts applying my logic.

PS — weakly related, also consider the pervasiveness of BlackRock’s risk control model.  Dominant risk control models may not truly control risk, because who will they sell to?  Just another imbalance of which to be wary.

One More Note on Failure

Saturday, July 12th, 2014

Recently, we had a problem at the Merkel house: a toilet overflowed and the water did not shut off, flooding the room, and leaked into the basement.  Why did this happen?  Two things went wrong at the same time:

  1. The toilet needed to be plunged, because there was a blockage preventing water discharge, and
  2. The flapper malfunctioned, and so water continued to flow.

If only one of these problems had happened, we would have had an ordinary problem.  I can plunge a toilet, easy.  I can hear the toilet singing, and know that the flapper is up, jiggle the handle, and end the problem.

Most of the time, when we plan against failure, we look at solutions that address single failures.  We do not contemplate two things going wrong at once.

Yet, when we look at big failures in investment, there are often two things that went wrong at the same time.  Usually it follows a pattern like this:

  1. Take a risk that in ordinary times often works out, but
  2. You don’t get that times are not ordinary, and so the odds are actually stacked against you.

I have several examples for this.  Taking on debt to buy a house was a wonderful strategy until overall debt levels to finance housing got to high, but at that time, the momentum effect of rising house prices was sucking people into buying houses, because they thought it was easy money.

Financial stocks were the market leaders for many years up through 2007, as investors assumed that ordinary risk control would protect the banking system.  But what happens when debt levels are too high, so that many debts are incapable of being paid?

As Warren Buffett has said (something like), “We get paid to think about the things that can’t happen.”  Multiple failures leading to large bad results are worth thinking about.  So what aren’t we thinking about now?

  • Failures in retirement security systems as the Baby Boomers age.
  • Failures in government debt as overleveraged governments can’t make debt payments.
  • Inflation rises rapidly as the economy revives amid increased lending from banks.
  • Deflation persists as the central bank tries to force-feed credit to an already overleveraged economy.

(There are many patting themselves on the back thinking that the Central Banks and Governments got us out of a crisis, when they only delayed the crisis.  High nominal debt levels relative to GDP create their own crisis.)

I would encourage you to think about your investments, and ask the following questions:

  • Are there hidden factors that could lead to a big failure?  (Think of what happened to mortgage REITs in 2008 when the repo market crashed.)
  • How well would the investment fare if inflation went up significantly?
  • How well would the investment fare if real interest rates went up significantly?
  • How well would the investment fare if we hit another patch where financing is not available?  Can the investment self-fund?
  • How much future prosperity does the current price of the investment embed in its valuation?

I know, glum words.  But this might be a good time to look at what you own, and ask how survivable it is under stressed conditions.

All for now.

Inflation?

Friday, June 27th, 2014

Is price inflation growing?  I see three data points, amid slow nominal growth:

  • Japan
  • US
  • Crude Oil prices have been rising, amid the relaxation of exports in the US, and weak global demand.

This is early, but I have adjusted my bond portfolio to reflect this last month, buying some TIPS.

This is not worthy of full action, but it is interesting to see the three above rising at the same time.  That’s all.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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